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February 18, 2014

Contrarian Ketterer Unfazed by Emerging Market Turmoil

For Sarah Ketterer's Causeway Capital, the emerging markets upset is a buying opportunity

There’s a whole lot of shaking going on in battered emerging markets. But … it’s a cycle, folks!

In an interview with ThinkAdvisor, the co-founder and CEO of Causeway Capital Management, specializing in international, global and emerging markets equities, declares unequivocally that, like all cycles, this one will turn.

For Causeway, with $26 billion under management from institutional and retail investors, the emerging markets upset is a buying opportunity.

Ketterer, with firm co-founder and president Harry W. Hartford and team, was nominated for Morningstar International Stock-Fund Manager of 2013. Causeway's 4-star flagship $4.8 billion International Value Fund (CIVVX) delivered a 23.9% return. With five mutual funds, Causeway invests in major equity markets around the world.

Emphasizing a long-term view, Ketterer’s contrarian approach proved successful even in the dark days of the financial crisis, when she invested in stocks that others fearfully dismissed.

The Pasadena, Calif.-born Dartmouth MBA, 53, started out at Bankers Trust in New York in leveraged lending and mergers and acquisitions, then opened her own database company before founding the international equity strategy at Hotchkis and Wiley in 1990. Hartford joined her four year later. In 2001, they launched Causeway.

ThinkAdvisor talked with the high-energy Los Angeles-based Ketterer about her secrets to successful investing and how experience can often be the best teacher — and disciplined investors, the best learners.

ThinkAdvisor: Is it exciting to invest in what others are fleeing from or snubbing?

Sarah Ketterer: That defines investing. If you don’t have your own well-grounded opinion, you won’t make any money. The key is that you’ve got to see something other people don’t — in the company, in its industry, its financial statements — and then take advantage of that. But contrarianism is a byproduct: I’m not going out to be a contrarian.

Emerging markets are troubling. What’s going on?

This is a tough period. Some emerging markets have been so dependent on foreign capital inflows and have incurred so much domestic debt that they’re in a somewhat precarious position. As foreign funds flow out and investors get nervous, an imbalance is created, and the countries that are suffering have to attract capital back.

How do they do that?

By raising interest rates. But this has a dampening effect on their economic activity. So in some cases, growth is slowing to a crawl – certainly in Turkey and Hungary, and maybe Brazil, South Africa, Indonesia and India as well. Because interest rates had to rise to crimp this excess in credit and support the domestic currency, the economy stagnates, and growth slows; yet they still have inflation problems.

What does all that mean to the emerging markets investor?

This is a cycle. That’s what people forget. We’ve seen it over and over again, perhaps most vividly in the late 1990s in Asia. There will be some adjustment. The countries that come out of it OK are the ones that have natural resources — assets — like South Africa and Brazil. Turkey, on the other hand, doesn’t have much, though in contrast to China, they do have a very young working population, a huge asset.

Is now a good time to buy emerging markets?

It might be a little bit early to be buying more emerging — but not too early. The problem with buying something cyclical is that you never know where the bottom is. Emerging markets look very cheap on almost every measure whether it’s dividend yields, price-earnings ratios, return on capital. So if you’re an investor who understands how to buy cyclical stocks or markets, this may be a good time to start accumulating because the cycle does turn. That way, you’ve bought at a low entry point as opposed to waiting till there’s good news, in which case, it’s too late because the valuations will have re-rated upward again.

So the current situation is a buying opportunity for you?

We think so. Emerging markets are generally growth markets, and investors are typically willing to take on more macroeconomic and political risk to get access to that growth than they would in the developed world. You have to dollar-cost-average your way in. Every couple of weeks we allocate a little bit more to emerging markets because we know the valuations are attractive — but we don’t know where the bottom is.

Is that strategy in sync with your being a contrarian?

It’s in sync with experience. We’ve seen this before.

Some financial advisors tell clients that emerging markets are very risky, so they should buy them via ETFs.

(Laughs) That’s ridiculous! An [exchange-traded fund] is simply a passive allocation to an emerging market. Whether it be active or an ETF, the key is not to take on too much risk in any one market. In our Emerging Markets fund, we have a very broad allocation across a variety of markets and constraints relative to market weights in the benchmark of the Emerging Market Index.

Where does the real riskiness come in?

We take our bets in stock selection, where we’re experts. But one needs to be somewhat careful about loading up on Russia or India, for example, because it’s very difficult to determine the next political change; and that could have an overwhelming impact on the stock. Even if the valuations are attractive, the stocks may go down much further if the political environment becomes less sanguine.

What’s your outlook for emerging markets?

We’re more optimistic on some than on others. China is the one fly in the ointment. We’re somewhat neutral on our expectations for the Chinese economy if it’s going to be a slow, gradual shift from one that’s been very export-oriented to an economy with more domestic consumption. This shift has already started, and it means that we’re in a slower growth environment.

Why are China’s problems so significant in the grand scheme?

It’s such a large component of emerging markets and has demand for commodities and energy. Three-plus years ago China’s growth was in the double digits; now we’re looking at real GDP growth at somewhere around 7% to 7 1/2% at best, with an aging population — byproduct of the one-child policy — and a tremendous amount of private-sector debt.

Sounds ominous.

It all can’t come crashing down because China runs a closed capital account — so the country can hide a lot of this excess credit. But as interest rates need to be higher to squeeze out some of the excess lending, that will slow growth even further. And the slower China grows, the more problematic it becomes for the global economy, as well as for the domestic political situation, which we think depends very heavily on job creation and an ebullient economic environment.

What’s the worst-case scenario for emerging markets?

We’re not looking for a blowup in any place expect for those that are already disasters, like Argentina and Venezuela.

What’s a bright spot?

Turkey has doubled its short-term interest rate. That may lead to companies who borrowed having more trouble repaying their loans. But this will quickly resolve the credit-excess problem and should put the country back on a much healthier plane within the next 12 months.

What’s the secret to your funds’ outstanding performance?

There are multiple secrets — one of them is having an investment horizon longer than the average investor. This gets back to investing in emerging markets. Investors tend to be very short-term, and the enormous growth of hedge funds has exacerbated the situation. A six-month time horizon is all anyone has anymore. They expect the stocks to deliver right away. They have no tolerance for volatility or disappointment. But you’re investing — you’re not trading. It’s buying a business, and you’ve made an assessment of its valuation. And then you wait. Ideally, while you wait, you get paid a dividend, so there’s some compensation for being patient.

How long does it usually take for a turnaround?

Two to three years from when we buy our companies to rectify the problem that made them value stocks to begin with. So we have to wait a long time. That’s why we want some income through dividends, share buybacks — any way of lowering the duration of the investment. We want to make sure we don’t have to rely entirely on capital gains. But at the same time, a really well diversified portfolio will have some stocks that are near their price targets — and then there’s everything in the middle.

What’s another of your secrets of success?

We encourage clients to give us as much leeway as possible — the more markets the better. Since we’re all about delivering performance, we don’t have a single investment strategy that involves one market.

Your expectations for the equities that you own now?

We’re holding a very concentrated number of stocks, and they should deliver. They don’t always do it with low volatility, though, and that’s always the rub. I’m very pleased with the performance, but I would be even happier if we could do it with very little volatility.

Do you hopscotch the globe to visit companies in which you’re interested?

These days, I’m very selective. My last trip was in December to China, Hong Kong, Singapore and Australia especially to see property companies because of the concern that’s been swirling around the markets about a bubble emanating from China, and whether commercial and residential properties are too high-priced. Sometimes, especially with property, you need to see this stuff. You need to walk through the buildings and see the lots and meet with management and look them in the eye.

Why did you visit companies in Australia?

As the demand for commodities slows and one would think that would slow the Australian economy, we believe there might be some opportunities to buy investment property stocks there. And the other really interesting angle is companies that are buying into storage facilities because there’s been so much economic growth in Asia. Companies that have warehouses are finding ways of taking advantage of the advent of Internet shopping. There’s a need for more and more warehouse space.

You’re known for unconventional approaches to investing. What’s your main concern when implementing that?

The key to unconventional is that we have to take as little risk as we can. We engage in unconventional at the very bottom of equity markets.

What’s a recent example?

Lately, both internationally and globally, we’ve decided to buy airlines. We normally don’t because we think they’re awful — a high fixed-cost business in over-capacity markets. But what we saw for IAG — parent company of the merged British Airways and Iberia — was tremendous wage concession in Spanish airlines for the first time ever, and that the trans-Atlantic route is hugely profitable for British Airways, as many competitors have dropped away. Also, we anticipate consolidation in Continental Europe, just as we’re seeing in the U.S.

At what juncture did you buy?

We bought this stock early enough, when investors were concerned about the slow European economy and not seeing underlying trends in capacity in commercial aviation. We did the same thing with American Airlines — we bought it before the US Airways merger. The stocks have really delivered in a market that’s just been trading sideways this year.

I trust you made some unconventional investments during the financial crisis!

In 2009, when [it was announced] that the financial markets were on the brink of collapse and it was a very scary time to be investing, we decided that, rather than hide out in cash or buy a bunch of pharmaceutical stocks, we’d buy companies that were highly cyclical but leaders in their field — the absolute best in class.

Such as?

Fanuc, a robotics and industrial automation company in Japan. Our clients were terrified of massive global recession, but we said, “This company will last longer than all its peers.” We knew that ultimately there would be [an increasing] move of capital away from labor, and they are well positioned for that. There’s so much excess cash sitting there.

What else did you invest in during the meltdown?

We bought luxuries for the first time — we waited 10 years to do that. Nobody wanted Richemont, based in Switzerland, which owns Cartier. They didn’t want to touch [luxury] stocks because they thought there would be no discretionary spending. But, again, if they just looked a little further than the end of their nose — more than six months — to two to three years out in anticipating a recovery of some type, these were tremendous bargains. Those companies have absolutely unassailable balance sheets — the Bomb could go off, and they would still be there.

Didn’t you feel any uncertainty when you were buying them at that terrible time?

No. we knew we did the right thing. But our clients were hyperventilating because they wanted us to be in something safe. We said, “This is as good as it’s going to get.” We didn’t buy the biggest-return stocks in 2009; that is, the ones that had financial leverage — banks, in particular. We didn’t need to take that type of risk, having no idea when there would be a recovery both in the U.S. and globally. So I slept very well at night. But it took quite a bit of time and effort to convince clients that this was a unique opportunity to own some of the world’s best companies.

We know we’ve got great stocks to start with — but now the question is, how can we narrow the field even further? For our international and global funds, there’s no other way to go through 3,000 stocks than quantitative screening. The quant effort measures the incremental amount of volatility, or risk, that every stock will add to our portfolio. Every stock has risk baggage — a handicap that it has to overcome. The risk scores are the major insight we have into diversification.

For example?

We’re now looking at another transportation stock in Europe, and the risk score is beginning to balloon. So we know that if we buy this stock, we have to buy it at a very low price in order to overcome this risk. Having the fundamental and quant fused allows us to build a really diversified portfolio with the highest amount of return for every unit of risk.

Why did you decide to focus on international in the first place?

We came from a firm in Los Angeles that in 1990 needed international equities, and we started international there. After Merrill Lynch bought the firm and then wanted to sell it, we decided we needed to leave because we just couldn’t work for another large employer who didn’t understand our business. So we kept the team together and in 2001 formed Causeway. We brought over the one skill we had, which was international equity, and our clients followed. Then we built out our research so that it was truly global-industry oriented. In 2006 we added emerging markets.

That L.A. firm was institutional money manager Hotchkis and Wiley. Your father is founder John Hotchkis, who hired you as a consultant when he was considering getting into international equity.

Right. Then I got a full-time offer to be a part of starting that effort; and I thought, “You know what? I’ll take it!” In order to avoid any perception of nepotism, I was put across the hall in this whole other area behind a vault door. There was a gentleman working with me, who didn’t really do anything but read the paper, and an assistant. We were the international equity group, but nobody spoke to us. We had no interaction with domestic equity. It was bizarre.

What’s the secret of your own professional success?

Patience and lack of emotion. One of the biggest foibles that plagues investors is that they get emotional about stocks. They get very excited and hold their winners too long because it’s a boost to their ego. They tend to dump their losers at just the wrong time because they’re terrified. I tell our junior people that when there’s a crisis and the whole world falls apart and the floor falls out from under your investment and you think, “What have I got wrong here?” to go back in a very unemotional way and evaluate their assumptions, validate them and stick with them. Almost always that pays off.

What’s your top strength as a fund manager?

There’s a certain amount of psychological backbone you need to be a really good investor — and it doesn’t just come from experience. You cannot put your own ego on the line.

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